1. Banks
Chapter 2
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

2. Nature of Banking Commercial banking Investment banking
Taking deposits, making loans
Wholesale vs retail
Money center banks
Investment banking
Raising debt and equity for companies; advice on mergers and acquisitions, restructurings, etc
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

3. Structure of Banking in the US
Large international banks (small number)
Regional banks (several hundred)
Small community banks (several thousand)
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

4. History of Bank Regulation in US (page 21)
McFadden Act (1927, 1933)
Douglas Amendment (1956)
Bank Holding Companies Act (1970)
Riegel-Neal Interstate Banking and Branching Efficiency Act (1994)
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

5. Example of Simple Bank Balance Sheet: End 2009 (Table 2.2, page 22)
Assets
Cash
Marketable Securities 10
Loans
Fixed Assets
Total
Liabilities
Deposits
Subord L.T. Debt
Equity Capital
Total
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

6. Income Statement: 2009 (Table 2.3, page 23)
Net Interest Income 3.00 Provision for Loan Losses (0.80) Non-Interest Income 0.90 Non-Interest Expense (2.50) Pre-Tax Operating Income 0.60
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

7. Year 2010
What happens in year 2010 if it is the same as year 2009 except that provision for loan losses is 4.0 instead of 0.8?
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

8. What if Balance Sheet Had Been More Aggressive?
Assets
Cash
Marketable Securities 10
Loans
Fixed Assets
Total
Liabilities
Deposits
Subord L.T. Debt
Equity Capital
Total
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

9. Regulation
Regulators set minimum levels for the capital a bank is required to keep
Equity is an example of Tier 1 capital
Subordinated long term debt is an example of Tier 2 capital
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

10. Deposit Insurance (pages 24-25)
Most countries have deposit insurance programs that insure depositors against losses up to a certain level
In the US the FDIC has provided protection for depositors since 1933
The amount insured was $2,500 in 1933
It has been increased several times
Following the credit crisis it was increased from $100,000 to $250,000 in October 2008.
Why might deposit insurance encourage a bank to take risks?
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

11. Investment Banking Methods of raising debt or equity Public offering
Private placement
Best efforts
Firm commitment
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

12. Best Efforts vs Firm Commitment (pages 25-26)
50 million shares are to be issued and target price is $30 per share
Best efforts would lead to a fee of 30 cents per share; firm commitment leads to bank buying at $30 per share
Best efforts
Firm Commitment
Can sell at $29
+$15 million
−$50 million
Can sell at $32
+$100 million
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

13. Initial Public Offering (IPO)
Usually on a best efforts basis
Bank will set offering price sufficiently low that shares are almost certain to be sold
Often price rises immediately after IPO
Banks often offer shares only to fund managers and their best customers
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

14. Dutch Auction IPO
Individuals and companies bid by indicating the number of shares they want and the price they are prepared to pay
The price paid is the lowest bid that leads to all the shares being sold
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

15. Example: How are 1 million shares allocated in this situation
Example: How are 1 million shares allocated in this situation? (page 27, Example 2.2)
Bidder
Number of Shares
Price A
100,000
$30.00 B
200,000
$28.00 C
50,000
$33.00 D
300,000
$29.00 E
$30.50 F
$31.50 G
400,000
$25.00 H
$30.25
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

16. Google’s IPO in 2004 (Business Snapshot 2.1, page 28)
A Dutch Auction where Google retained the right to change the number of shares that would be issued and the percentage allocated to each bidder
Investors who bid $85 or more obtained 74.2% of the shares they had bid for
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

17. Securities Trading Exchange-traded vs OTC Why do banks trade?
Brokerage services
Full service
Discount
On line
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

18. Potential Conflicts of Interest
Bank recommends securities investment bank is trying to sell
Commercial bank passes confidential information on a client to investment bank
Stock recommended as a “buy” to please company’s management in order to get investment banking business
Investment bank sell securities for a company so that commercial bank can get rid of a loan
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

19. Accounting (page 32) Banking book vs trading book
Nonperforming loans are loans where interest is not accrued. Typically, payments from the borrower are more than 90 days overdue.
When it becomes clear that payments will not be made, there is a loan loss
A bank creates a reserve for loan losses
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009

20. The Originate-to-Distribute Model
Very popular until the credit crunch of 2007
Banks originated loans and then packaged them into products that were sold to investors
This frees up funds to make more loans
Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009